Thursday, August 23, 2007

If the U.S. discount brokerage industry is indeed poised to undergo another round of consolidation, few people can match the kind of cards that Ed Clark is holding.

There is a significant wrinkle, though: The head of Toronto-Dominion Bank is playing a pair of hands at the same time.

Speculation about online brokerage mergers was revived yesterday after a report suggested TD Ameritrade Holding Corp., of which Mr. Clark's bank owns just under 40 per cent, has been in secretive talks about combining with archrival E*Trade Group Inc.

On paper, at least, a deal between the second- and third-largest players in this industry would seem to make a great deal of sense: Because of the excess capacity of their technology platforms, the two could slash overlapping trading costs and potentially deliver huge savings to shareholders.

Both companies confirmed yesterday they are always willing to discuss a deal that would create value. Privately, however, sources close to TD Ameritrade and E*Trade said nothing has happened in the past several weeks to suggest a deal is imminent.

This shouldn't come as a complete surprise.

For Mr. Clark, TD Ameritrade represents just one leg of his U.S. expansion strategy. An issue he must weigh is whether it's better to invest further in the discount brokerage business, or look at bulking up his underperforming U.S. retail bank, TD Banknorth Inc., amid a climate of declining regional bank values.

The discount brokerage option would seem to yield much higher returns for shareholders, but it's not an easy solution - especially if TD wants to remain a dominant minority owner. For one thing, TD would likely have to contribute about $2.4-billion (U.S.) if it expects to maintain a 40-per-cent stake in a merged TD Ameritrade-E*Trade. Because discount brokerage acquisitions bring with them a substantial amount of goodwill, that could hurt TD's balance sheet at a time when the credit markets are already causing banks serious consternation.

TD has about $9-billion worth of goodwill on its books - almost as much as the rest of the Canadian banking industry combined. Goodwill essentially measures intangible assets, such as the worth of a company's brand: It is the difference between a company's book value, and the overall price it can fetch from an acquirer.

Adding more goodwill would put serious pressure on TD's Tier One capital ratios, a key measure of capital strength that regulators use to assess a bank's financial health.

A regional bank purchase, by contrast, would not likely have the same goodwill problem. Although the credit crunch has made some of these banks sketchy targets, tumbling stock prices in the sector could yield some bargains. The KBX regional bank index is down almost 10 per cent so far this year, and had fallen more than 20 per cent earlier this month.

Even if Mr. Clark shies away from any deal making in the retail sector, where TD has struggled, there are other reasons to be skeptical about a TD Ameritrade merger with E*Trade.

One significant obstacle is culture. Mr. Clark worked on a possible merger of TD Waterhouse Group Inc. and E*Trade a few years ago, but the deal fell apart after the two sides could not agree on who would take key executive roles in the new company.

Sources close to TD said the bank has a more positive view of E*Trade chief executive officer Mitch Caplan than it did at the time of the merger talks, though it's still not clear whether E*Trade and TD Ameritrade would be able to agree on who would run the show.

Michael Hecht, an analyst at Bank of America, flagged this as one of a handful of issues that he predicted will "ultimately prevent a deal." He also said in a report that credit quality concerns in E*Trade's loan book (the company has a small banking operation) could pose a stumbling block, and suggested that E*Trade's commission-driven model would not help TD Ameritrade's strategy of shifting more of its business toward fee revenues. While Mr. Hecht predicted a merger could produce cost savings of 45 per cent, he noted that these sorts of synergies haven't produced the kind of earnings growth that investors were anticipating when TD Waterhouse and Ameritrade struck their agreement. Indeed, since mid-2005, when the deal was announced, earnings per share have remained flat, he said.

News of merger talks, reported in the Wall Street Journal yesterday, come just months after two hedge funds raised concerns about TD's influence at TD Ameritrade, and lobbied the company to remove TD executives from its merger committee.

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Financial Post, Duncan Mavin, 23 August 2007

A merger involving TD Ameritrade appeared more likely yesterday after revelations in U.S. media the firm has held weeks of talks with rival online brokerage E*Trade Financial.

However, the nature of a possible deal and what it could mean for Toronto-Dominion Bank, a part owner of TD Ameritrade, remain far from certain.

TD owns 39% of Ameritrade. A deal with another U.S. broker, if it happens, could see a range of outcomes, including TD taking a smaller share in a bigger entity or exiting the sector altogether.

"I think a deal will happen and I think E*Trade will be the surviving brand," said Robert Ellis, an analyst with Celent LLC.

TD's executives could be interested in selling out during "a bull market that is at or near the top," Mr. Ellis said. "If you were interested in cashing out, now would be a good time to do it."

However, TD's executives may be more interested in extending their investment in a combined firm that would likely benefit from synergies of scale.

"TD's ownership in a combined entity would be approximately 25%, giving it more flexibility to increase its stake," said Blackmont Capital analyst Brad Smith.

The recent deal rumours were sparked by a report in yesterday's Wall Street Journal that said E*Trade and TD Ameritrade have held talks over several weeks.

The report, which also said the two sides are not close to a deal, follows months of speculation about consolidation in the U.S. online-brokerage sector, where TD Ameritrade and E*Trade are dominant players alongside Charles Schwab.

TD Ameritrade has acknowledged that it "has had and expects to continue to have discussion with its peers in the industry regarding mergers and acquisitions." Joe Moglia, chief executive, has also recently confirmed the broker is talking to other parties about a possible deal.

But some observers question whether a deal is even on the cards at all.

"While we have long understood the synergies of a potential deal, the number of hurdles to overcome continues to mount," said UBS Investment Research analyst Michael Carrier.

The obstacles include a possible clash of strong management teams at the two brokerages.

The online brokerage industry, which underwent a wave of consolidation after the bursting of the dot-com bubble, may be headed for another shakeout, with giants TD Ameritrade Holding Corp. and E*Trade Financial Corp. holding merger discussions.

A merger of the two online brokers would create a dominant player in what has been a highly fragmented industry, with dozens of smaller companies battling for market share. As a result, it could reduce some of the fierce competition that has benefited consumers by driving down the cost of online trading but has squeezed the industry by chipping away at its profit margins.

As of the end of June, E*Trade had 4.7 million brokerage and banking accounts, TD Ameritrade had 6.3 million such accounts, and Charles Schwab Corp., now the largest online broker, had about 6.9 million. Merrill Lynch & Co., in contrast, has more than 7 million customer accounts.

A spokeswoman for E*Trade said the firm's management team has consistently stated it believes there is "tremendous value in consolidation that aligns business strategy and operational synergies and will do what is in the best interest of its customers." A TD Ameritrade spokeswoman said, "We have talked and continue to talk to peers in the industry."

E*Trade and TD Ameritrade have been in serious discussions for weeks but aren't yet close to a deal, according to people familiar with the matter. They have discussed an alliance several times in previous years but have never managed to make it to the altar. This time, however, they may feel more pressure to reach a deal. Two hedge funds with big stakes in TD Ameritrade have publicly urged the two companies to talk.

The two funds -- Jana Partners LLC and S.A.C. Capital -- have argued that Toronto-Dominion Bank, which owns 39% of TD Ameritrade, opposes a merger of the company because its interests aren't fully aligned with other shareholders. The funds, which own a combined 8.4% of TD Ameritrade, contend that the Canadian bank wants to use the online broker, which is based in Omaha, Neb., to grow in the U.S. and isn't necessarily focused solely on maximizing shareholder value. TD Bank has publicly disagreed with that characterization of its position.

Even so, Jana and S.A.C. successfully pressured TD Ameritrade to remove TD Bank's chief executive from the online broker's mergers and acquisitions committee in early July.

It isn't clear what a merger deal between E*Trade and TD Ameritrade would be worth or how it might be structured. One person familiar with the talks estimated a deal could create a company valued at as much as $20 billion, given the cost saving that could result from uniting both company's accounts on a single computer system. The consolidation would make the cost of adding new clients minimal.

Yesterday, E*Trade shares rose 93 cents to close at $15.57 in 4 p.m. composite trading on the Nasdaq Stock Market. TD Ameritrade, which also trades on Nasdaq, closed at $16.35, up 17 cents. TD Ameritrade currently carries a market capitalization of $9.74 billion while E*Trade's stock value is $6.6 billion.

A person familiar with the merger talks said the discussions currently are focused on making sure both online brokers agree on strategy. Ameritrade historically has been known as king of the low-cost trade while E*Trade has pursued a more diversified strategy and even owns a bank. In recent years, though, both firms have become more focused on offering customers an array of products.

Since the Internet bubble burst, the sector has been beset by falling commissions. New York-based E*Trade, for instance, now charges between $6.99 and $9.99 a trade. In 1997, by contrast, Schwab Corp. made headlines by offering the then-bargain price of $29.95 for online trades of up to 1,000 shares. At the time, Schwab insiders worried that such a price cut -- trades had cost roughly three times that amount before -- would eat up profits.

Today, the competition for low-cost trades is even fiercer. Some banks, including Bank of America Corp. now offer free online trades for customers who meet certain minimum-balance requirements. In Bank of America's case, customers must have at least $25,000 in deposits to qualify.

With private-equity firms shrinking from the acquisition scene amid the current credit crunch, traditional mergers among industry rivals like TD Ameritrade and E*Trade may be the surest path for such companies to reach a deal. Such a deal might also be subjected to less antitrust scrutiny now under the business-friendly Bush administration than if it came up for review under President Bush's eventual successor.

In recent years, a number of deals between major competitors have passed antitrust muster, including appliance maker Whirlpool Corp.'s acquisition of Maytag Corp. and the merger of the nation's largest and second-largest hog producers, Smithfield Foods Inc. and Premium Standard Farms Inc.

The credit crunch, however, has added a new wrinkle to the TD Ameritrade-E*Trade talks: Last week E*Trade was hit with rumors that the quality of its mortgage portfolio, a growth engine for the company in recent years, was weak. The company's stock's dropped 28% last Thursday before rebounding the same day after E*Trade assured the market that despite some volatility, "the financial health of the company is sound."

Still, sources close to the negotiations say the quality of E*Trade's mortgage portfolio is an issue TD Ameritrade is watching closely.

Eventually, those involved in the talks say they expect the sticking points to be familiar ones: The two sides will need to agree on a management team to run the combined company and, on a related note, what degree of control Ameritrade shareholder TD Bank would have once the two brokerage firms were combined.

Picking a management team won't be easy. Both companies are run by forceful chief executives: Mitch Caplan at E*Trade and Joe Moglia at TD Ameritrade. Control was a point of contention during Ameritrade's 2005 talks with TD Bank. Eventually Mr. Moglia got the CEO post and TD Bank acquired five of the company's 12 board seats.

A person familiar with the matter said the two companies were talking before hedge funds Jana and S.A.C. went public with their call for talks between the pair. This person said the move actually slowed down negotiations because TD Ameritrade has been working to address some of the concerns raised by the funds, such as removing the TD Bank CEO from its merger and acquisition committee.

A deal between E*Trade and TD Bank would put added competitive pressure on Schwab. During a conference call with analysts in July, Schwab Chief Executive Charles Schwab threw cold water on speculation his firm might merge, suggesting that its internal growth opportunities were superior to acquisition-related ones. Yesterday, a Schwab spokeswoman declined to comment.

Schwab, long criticized by analysts for its high expenses, has sought in recent years to cut costs. It also recently named Walt Bettinger as president and chief operating officer to help assuage some concerns that had been brewing on Wall Street about the depth of Schwab's management bench. In another move aimed at getting its house in order, Schwab last year sold U.S. Trust to Bank of America. Schwab initially bought U.S. Trust in hopes of retaining more wealthy clients, but the marriage never worked, in part because of culture clashes between the two companies.